The Next Risk To The Global Financial System Could Be China’s ‘Belt And Road’ Initiative

Promoting economic prosperity and fostering diplomatic ties on a global scale is the aim of China’s mammoth, pan-Eurasian “Belt and Road” infrastructure initiative.

That rhetoric comes with risks, and increasing levels of state-backed funding have raised concerns about just how safe of a gamble it is even though it may win plaudits at a time when other global powers are voicing increasingly protectionist agendas.

The initiative, also known as “One Belt, One Road,” aims to connect more than 60 countries across Asia, Europe and Africa with physical and digital infrastructure and some of China’s biggest state-owned commercial banks will begin raising capital to fund investments into the initiative, reports on Tuesday claimed.

Reuters reported that in order to raise at least 100 billion yuan ($15 billion) from on- and offshore investors, China Construction Bank, the country’s second-largest bank by assets, has been conducting roadshows. Also said to be raising tens of billions of dollars is the Bank of China, Industrial and Commercial Bank of China and Agricultural Bank of China.

If the projects fail, the risk that the state could amass hundreds of billions of dollars in nonperforming loans is highlighted by the news. It was not a surprise for Xu Chenggang, professor of economics at Cheung Kong Graduate School of Business in Beijing.

“A risk to China’s banking system is, by default, a risk to the global banking system”-Bjorn Conrad, vice president at the Mercator Institute for China Studies

“It supports my concerns,” Xu told CNBC over the phone. “The impact could be damaging not just for China, but for the global financial system.”

“These loans are being extended to governments in risky countries to fund risky infrastructure projects. If the projects were launched by private firms we wouldn’t have to worry because they would know they had to bear the consequences. But here we are talking about government-to-government lending and, ultimately, intergovernmental relations.”

A phenomenon known as soft budget constraints was picked as the reason by Xu.

Because the state has vested interests in keeping them afloat and therefore state-owned firms will not be allowed to go bankrupt if they go insolvent and this is the idea of soft budget constraints. And therefore, global financial implications can happen when a large number of insolvent firms may struggle for financing in a country with high soft budget constraints.

This is a matter of particular concern for a country like China, where state-ownership has historically been high. Before it succeeded in what Xu termed a process of “quiet privatization” at the turn of the 21st century, it took decades of economic reforms and loss-making firms.

However, especially within the metals and construction and materials sectors, the state remains burdened with issues of overcapacity and myriad “zombie firms,” and the process has lost momentum over the past 10 years.

That has partially been the motivation for the “Belt and Road” initiative, Xu said: “Instead of solving the overcapacity problems, they are expanding the problem to projects overseas.”

“They (China) are proposing lending money to foreign governments, who will then use the Chinese funds to pay the Chinese companies,” he explained.

According to the Institute for International France, China’s debt to gross domestic product (GDP) ratio surpassed 300 percent in June.

“Expansion of these soft budget constraints at such an unprecedented rate and in such a large scale is going to generate unprecedented consequences,” Xu noted.

Crucially, some of the riskiest developing countries in the world are the countries that are tied to the “Belt and Road” initiative. Risk assessing the political, economic and business landscapes of the involved nations are now being done by a number of research bodies.

“There is no doubt in my mind that there will be a large number of projects that will have unforeseen problems,” Bjorn Conrad, vice president at the Mercator Institute for China Studies, said. “There are considerable risks of nonperforming credit in many of these projects and high risks of default.”

“A risk to China’s banking system is, by default, a risk to the global banking system,” he continued.